PUTNAM v. COMMISSIONER(1956)
In a business venture not connected with his law practice, petitioner, a lawyer, organized a corporation, supplied its capital, and financed its operations through advances and guaranties of its debts. He wound up the corporation's affairs and liquidated its assets but did not terminate its corporate existence. Its assets were insufficient to pay its debts, and petitioner paid $9,005 of its debts in discharge of his obligation as guarantor. Held: In computing petitioner's income tax, this $9,005 loss was nonbusiness bad debt loss to be given short-term capital loss treatment under 23 (k) (4) of the Internal Revenue Code of 1939; and it was not fully deductible under 23 (e) (2) as a loss "incurred in [a] transaction . . . for profit, though not connected with [his] trade or business." Pp. 83-93.
Richard E. Williams argued the cause for petitioners. With him on the brief was A. Lyman Beardsley.
Philip Elman argued the cause for respondent. With him on the brief were Solicitor General Rankin, Assistant Attorney General Rice, Harry Baum and Joseph F. Goetten.
MR. JUSTICE BRENNAN delivered the opinion of the Court.
The petitioner, Max Putnam, in December 1948, paid $9,005.21 to a Des Moines, Iowa, bank in discharge of his obligation as guarantor of the notes of Whitehouse Publishing Company. That corporation still had a corporate existence at the time of the payment but had ceased doing business and had disposed of its assets eighteen months earlier. The question for decision is whether, in the joint income tax return filed by Putnam and his wife for 1948, Putnam's loss is fully deductible as a loss "incurred in [a] transaction . . . for profit, though not connected with [his] trade or business" within the meaning of 23 (e) (2) of the Internal Revenue Code of 1939, 1 or whether it is a nonbusiness bad debt within the [352 U.S. 82, 84] meaning of 23 (k) (4) of the Code, 2 and therefore deductible only as a short-term capital loss.
The Commissioner determined that the loss was a nonbusiness bad debt to be given short-term capital loss treatment. The Tax Court 3 and the Court of Appeals 4 for the Eighth Circuit sustained his determination. Because of an alleged conflict with decisions of the Courts of Appeals of other circuits, 5 we granted certiorari. 6
Putnam is a Des Moines lawyer who in 1945, in a venture not connected with his law practice, 7 organized Whitehouse Publishing Company with two others, a newspaperman and a labor leader, to publish a labor newspaper. Each incorporator received one-third of the issued capital stock, but Putnam supplied the property and cash with which the company started business. He also financed its operations, for the short time it was in business, through advances and guarantees of payment of salaries and debts. [352 U.S. 82, 85] Just before the venture was abandoned, Putnam acquired the shares held by his fellow stockholders and in July 1947, as sole stockholder, wound up its affairs and liquidated its assets. The proceeds of sale were insufficient to pay the full amount due to the Des Moines bank on two notes given by the corporation and guaranteed by Putnam for moneys borrowed in August 1946 and March 1947.
The familiar rule is that, instanter upon the payment by the guarantor of the debt, the debtor's obligation to the creditor becomes an obligation to the guarantor, not a new debt, but, by subrogation, the result of the shift of the original debt from the creditor to the guarantor who steps into the creditor's shoes. 8 Thus, the loss sustained by the guarantor unable to recover from the debtor is by its very nature a loss from the worthlessness of a debt. This has been consistently recognized in the administrative and the judicial construction of the Internal Revenue laws 9 which, until the decisions of the [352 U.S. 82, 86] Courts of Appeals in conflict with the decision below, have always treated guarantors' losses as bad debt losses. 10 The Congress recently confirmed this treatment in the Internal Revenue Code of 1954 by providing that a payment by a noncorporate taxpayer in discharge of his obligation as guarantor of certain noncorporate obligations "shall be treated as a debt." 11 [352 U.S. 82, 87]
There is, then, no justification or basis for consideration of Putnam's loss under the general loss provisions of 23 (e) (2), i. e., as an ordinary nonbusiness loss sustained in a transaction entered into for profit. Congress has legislated specially in the matter of deductions of nonbusiness bad debt losses, i. e., such a loss is deductible only as a short-term capital loss by virtue of the special limitation provisions contained in 23 (k) (4). The decision of this Court in Spring City Co. v. Commissioner, 292 U.S. 182 , is apposite and controlling. There it was held that a debt excluded from deduction under 234 (a) (5) of the Revenue Act of 1918 was not to be regarded as a loss deductible under 234 (a) (4). Chief Justice Hughes said for the Court:
The decisions of the Courts of Appeals in conflict with the decision below turn upon erroneous premises. 12 It is said that the guarantor taxpayer who involuntarily acquires a worthless debt is in a position no different from the taxpayer who voluntarily acquires a debt known by him to be worthless. The latter is treated as having acquired no valid debt at all. 13 The situations are not analogous or comparable. The taxpayer who voluntarily buys a debt with knowledge that he will not be paid is rightly considered not to have acquired a debt but to have made a gratuity. In contrast the guarantor pays the creditor in compliance with the obligation raised by the law from his contract of guaranty. His loss arises not because he is making a gift to the debtor but because the latter is unable to reimburse him.
Next it is assumed, at least in the Allen case, that a new obligation arises in favor of the guarantor upon his payment to the creditor. From that premise it is argued that such a debt cannot "become" worthless but is worthless from its origin, and so outside the scope of 23 (k). This misconceives the basis of the doctrine of subrogation, apart from the fact that, if it were true that the debt did not "become" worthless, the debt nevertheless would not be regarded as an ordinary loss under 23 (e). Spring City Co. v. Commissioner, supra. Under the doctrine of subrogation, payment by the guarantor, as we have seen, is treated not as creating a new debt and extinguishing the original debt, but as preserving the original debt and [352 U.S. 82, 89] merely substituting the guarantor for the creditor. The reality of the situation is that the debt is an asset of full value in the creditor's hands because backed by the guaranty. The debtor is usually not able to reimburse the guarantor and in such cases that value is lost at the instant that the guarantor pays the creditor. But that this instant is also the instant when the guarantor acquires the debt cannot obscure the fact that the debt "becomes" worthless in his hands.
Finally, the Courts of Appeals found support for their view in the following language taken from the opinion of this Court in Eckert v. Burnet, 283 U.S. 140 :
The objectives sought to be achieved by the Congress in providing short-term capital loss treatment for nonbusiness bad debts are also persuasive that 23 (k) (4) applies to a guarantor's nonbusiness debt losses. The [352 U.S. 82, 91] section was part of the comprehensive tax program enacted by the Revenue Act of 1942 to increase the national revenue to further the prosecution of the great war in which we were then engaged. 16 It was also a means for minimizing the revenue losses attributable to the fraudulent practices of taxpayers who made to relatives and friends gifts disguised as loans. 17 Equally, however, the [352 U.S. 82, 92] plan was suited to put nonbusiness investments in the form of loans on a footing with other nonbusiness investments. The proposal originated with the Treasury Department, whose spokesman championed it as a means "to insure a fairer reflection of taxable income," 18 and the House Ways and Means Committee Report stated that the objective was "to remove existing inequities and to improve the procedure through which bad-debt deductions are taken." 19 We may consider Putnam's case in the light of these revealed purposes. His venture into the publishing field was an investment apart from his law practice. The loss he sustained when his stock became worthless, as well as the losses from the worthlessness of the loans he made directly to the corporation, would receive capital loss treatment; the 1939 Code so provides as to nonbusiness losses both from worthless stock investments and from loans to a corporation, whether or not the loans are evidenced by a security. 20 It is clearly a "fairer reflection" of Putnam's 1948 taxable income to treat the instant loss similarly. There is no real or economic difference between the loss of an investment made in the form of a direct loan [352 U.S. 82, 93] to a corporation and one made indirectly in the form of a guaranteed bank loan. The tax consequences should in all reason be the same, and are accomplished by 23 (k) (4). 21 The judgment is
[ Footnote 2 ] "SEC. 23. DEDUCTIONS FROM GROSS INCOME.
[ Footnote 3 ] 13 CCH TC Mem. Dec. 458.
[ Footnote 4 ] 224 F.2d 947.
[ Footnote 5 ] Pollak v. Commissioner, 209 F.2d 57 (C. A. 3d Cir.); Edwards v. Allen, 216 F.2d 794 (C. A. 5th Cir.); Cudlip v. Commissioner, 220 F.2d 565 (C. A. 6th Cir.).
[ Footnote 6 ] 350 U.S. 964 .
[ Footnote 7 ] Petitioners abandoned in this Court the alternative contention made below that the loss was deductible in full as a business bad debt under 23 (k) (1).
[ Footnote 8 ] United States v. Munsey Trust Co., 332 U.S. 234, 242 ; Aetna Life Ins. Co. v. Middleport, 124 U.S. 534, 548 ; Howell v. Commissioner, 69 F.2d 447, 450; Scott v. Norton Hardware Co., 54 F.2d 1047; Brandt, Suretyship and Guaranty (3d ed.), 324; 38 C. J. S., Guaranty, 111; 24 Am. Jur., Guaranty, 125. Iowa follows this rule. Randell v. Fellers, 218 Iowa 1005, 252 N. W. 787; American Surety Co. v. State Trust & Sav. Bank, 218 Iowa 1, 254 N. W. 338. There is not involved here a question of the effect of state law upon federal tax treatment of Putnam's loss. Cf. Watson v. Commissioner, 345 U.S. 544 ; Lyeth v. Hoey, 305 U.S. 188 ; Burnet v. Harmel, 287 U.S. 103 .
[ Footnote 9 ] The bad debt deduction provisions of earlier Revenue Acts were enacted in 214 (a) (7) of the Revenue Act of 1921, 42 Stat. 239; 214 (a) (7) of the Revenue Act of 1924, 43 Stat. 269; 214 (a) (7) of the Revenue Act of 1926, 44 Stat. 26; 23 (j) of the Revenue Act of 1928, 45 Stat. 799; 23 (j) of the Revenue Act of 1932, 47 Stat. 179; 23 (k) of the Revenue Act of 1934, 48 Stat. 688; 23 (k) of the Revenue Act of 1936, 49 Stat. 1658; 23 (k) of the Revenue Act of 1938, 52 Stat. 460: and 23 (k) of the Internal Revenue Code of 1939, 53 Stat. 12.
[ Footnote 10 ] See, e. g., 2 Cum. Bull. 137; 5 Cum. Bull. 146; III-1 Cum. Bull. 158; III-1 Cum. Bull. 166; Shiman v. Commissioner, 60 F.2d 65 (C. A. 2d Cir.); Hamlen v. Welch, 116 F.2d 413 (C. A. 1st Cir.); Gimbel v. Commissioner, 36 B. T. A. 539; Roberts v. Commissioner, 36 B. T. A. 549; Sharp v. Commissioner, 38 B. T. A. 166; Hovey v. Commissioner, P-H 1939 B. T. A. Mem. Dec. § 39,081; Pierce v. Commissioner, 41 B. T. A. 1261; Whitcher v. Welch, 22 F. Supp. 763.
Similar decisions rendered since the Revenue Act of 1942 include: Ortiz v. Commissioner, 42 B. T. A. 173, reversed on another ground, sub nom. Helvering v. Wilmington Trust Co., 124 F.2d 156, reversed (without discussion on this point), 316 U.S. 164 ; Burnett v. Commissioner, P-H 1942 B. T. A. Mem. Dec. § 42,528; Ritter v. Commissioner, P-H 1946 TC Mem. Dec. § 46,237; Greenhouse v. Commissioner, P-H 1954 TC Mem. Dec. § 54,250; Estate of Rosset v. Commissioner, P-H 1954 TC Mem. Dec. § 54,346; Watson v. Commissioner, 8 T. C. 569; Sherman v. Commissioner, 18 T. C. 746; Aftergood v. Commissioner, 21 T. C. 60; Stamos v. Commissioner, 22 T. C. 885.
[ Footnote 11 ] "SEC. 166. BAD DEBTS.
[ Footnote 12 ] See n. 5, supra.
[ Footnote 13 ] Reading Co. v. Commissioner, 132 F.2d 306; W. F. Young, Inc. v. Commissioner, 120 F.2d 159; American Cigar Co. v. Commissioner, 66 F.2d 425.
[ Footnote 14 ] The basis for this statement came from the opinion of the Court of Appeals for the Second Circuit and was explained by that court in its later opinion in Shiman v. Commissioner, 60 F.2d 65, 67, as follows: [352 U.S. 82, 90]
[ Footnote 15 ] See Helvering v. Price, 309 U.S. 409 . The requirement that the debt be "ascertained to be worthless and charged off within the taxable year" was superseded in the Revenue Act of 1942, 124 (a), by the requirement that the debt be one which "becomes worthless within the taxable year."
[ Footnote 16 ] Chairman Doughton of the House Committee on Ways and Means opened the hearings on the bill which became the Revenue Act of 1942 with the statement: ". . . the meeting of the committee this morning is the first step in the consideration, preparation, and reporting of perhaps the largest tax bill that it has ever been the duty and responsibility of our committee to report.
[ Footnote 17 ] Petitioners argue that this was its sole purpose and that the section should be construed as limited in application to such loans. The context of the segment of the House Ways and Means Committee Report discussing this objective does not support the petitioners' argument. H. R. Rep. No. 2333, 77th Cong., 2d Sess. 45:
[ Footnote 18 ] Hearings before House Committee on Ways and Means on Revenue Revision of 1942, 77th Cong., 2d Sess. 90.
[ Footnote 19 ] H. R. Rep. No. 2333, 77th Cong., 2d Sess. 44.
[ Footnote 20 ] Section 23 (g) (2) and (3) as to worthless stock. Section 23 (k) (2) (3) and (4) as to loans. As Judge Stewart pointed out in his dissenting opinion in the Cudlip case, 220 F.2d, at 572:
[ Footnote 21 ] Upon this ground, contrary to the holding in Fox v. Commissioner, 190 F.2d 101, the guarantor's nonbusiness loss would receive short-term capital loss treatment despite the nonexistence of the debtor at the time of the guarantor's payment to the creditor.
MR. JUSTICE HARLAN, dissenting.
Being unreconciled to the Court's decision, which settles a conflict on this tax question among the Courts of Appeals and thus has an impact beyond the confines of this particular case, I must regretfully dissent.
The Court's approval of the Commissioner's treatment of petitioner's loss as one arising from a "nonbusiness debt," within the meaning of 23 (k) (4) of the Internal Revenue Code of 1939, 1 instead of as a loss incurred in a [352 U.S. 82, 94] "transaction entered into for profit," under 23 (e) (2), 2 rests on what is, in my opinion, a strained application of the equitable doctrine of subrogation. No one contends that petitioner acquired the Company's debt to the lending Bank when he entered into the agreement guaranteeing payment of that indebtedness. Rather, the Government's basic argument, as taken from its brief, is this:
Upon analysis, the Government's argument comes down to this: when the petitioner honored his guaranty obligation his payment was offset by the acquisition of the creditor Bank's rights against the Company on its indebtedness; in the Bank's hands those rights were worth full value, since the Company's indebtedness was secured by the guaranty; therefore petitioner's loss should be attributed to the subrogation debt, which became worthless in his hands because no longer so secured.
This argument would have substance in a case where the principal debtor was not insolvent at the time the guaranty was fulfilled; for in such a case it could be said that the acquired debt was not without value in the guarantor's hands, and hence he should not be allowed a tax deduction until the debt turns out to be worthless. But when, as here, the debtor is insolvent at the very time the guarantor meets his obligation, it defies reality to attribute the guarantor's loss to anything other than the discharge of his guaranty obligation. To attribute that loss to the acquired debt in such a case requires one to conceive of the debt as having value at the moment of acquisition, but as withering to worthlessness the moment the guarantor touches it. That the same debt in the same millisecond can have both of these antagonistic [352 U.S. 82, 96] characteristics is, for me, too esoteric a concept to carry legal consequences, even in the field of taxation.
It was this departure from reality which first led the Court of Appeals for the Second Circuit to reject the Commissioner's theory, as applied to a loss incurred by a widow upon a guaranty of her husband's brokerage account which she was called upon to honor long after his death and the winding up of his insolvent estate. Fox v. Commissioner, 190 F.2d 101. In that case the court, after referring to the "illusory character" of the subrogation claim which, the Tax Court held, she had acquired against her late husband upon her payment of the guaranty, went on to say, at pp. 103-104:
I cannot agree with the Court that either the circumstances under which 23 (k) (4) was enacted in 1942, or the provisions of 166 (f) of the Internal Revenue Code of 1954, 8 point to an opposite conclusion. Section 23 (k) (4) created a new category of debt losses, namely, [352 U.S. 82, 98] "nonbusiness debt" losses, which were thenceforth to be given capital loss treatment instead of the full loss deduction theretofore accorded them. 9 The Court finds the "objectives sought to be achieved by the Congress," through the enactment of this section, "persuasive that 23 (k) (4) applies to a guarantor's nonbusiness debt losses," in that the "section was part of the comprehensive tax program enacted by the Revenue Act of 1942 to increase the national revenue," in connection with World War II, and "was suited to put nonbusiness investments in the form of loans on a footing with other nonbusiness investments." But it seems to me that the House Ways and Means Committee Report on the bill shows that 23 (k) (4) was aimed at a specific narrow objective, namely, that of reducing revenue loss from the deduction of "family" or "friendly" loans which were in reality gifts. The Report states:
Likewise I think that the Court's reliance on 166 (f) of the 1954 Code is misplaced. That section provides that an individual taxpayer's guaranty payment discharging the obligation of a noncorporate debtor "shall be treated as a debt becoming worthless within such taxable year," and shall be deductible in full if (a) the proceeds of the guaranteed obligation were used "in the trade or business of the borrower," and (b) that obligation was worthless at the time the guarantor made payment. 13 The Court says that by enacting this section Congress confirmed the administrative practice of treating guarantors' losses as [352 U.S. 82, 100] bad debt losses, at least so far as guaranties of certain noncorporate obligations are concerned. I cannot agree, for again I think this section had a specific and limited purpose, which did not include the thrust which the Court now gives the section. That purpose, I think, was simply to permit deduction of certain guaranty payments that were not deductible at all under the 1939 Code. Payments now deductible under 166 (f) need not be made in the course of the guarantor's "trade or business," nor need they be attributable to a transaction "entered into for profit." They are deductible, it would seem, so long as the guarantor had some expectation of being repaid - so long, in other words, as the transaction was not a gift. Under prior law, such payments would not have been deductible as "business" debts, under 23 (k) (1), 14 or as losses on transactions "entered into for profit," under 23 (e) (2), or even as "nonbusiness" debts under 23 (k) (4), since the Fox line of cases held that such payments do not give rise to "debts." However, here again, as with the enactment of the 23 (k) (4) "nonbusiness debt" provision in 1942, Congress was concerned with fending against allowance of this type of deduction in cases of fictitious "family" or "friendly" guaranties. Hence it was unwilling to allow the deduction to all guarantors of individual borrowings. Considering guaranties of loans sought for business purposes to be free of such infirmities, Congress attempted to obviate abuse of 166 (f) by limiting its [352 U.S. 82, 101] application to guaranties of loans the proceeds of which "were used in the trade or business of the borrower."
In light of what seems to have been the particular congressional purpose, I think it strains 166 (f) to read it as broadly confirming the treatment of guaranty losses as bad debt losses. 15 Congress presumably knew of the Fox line of cases, supra, which had refused "debt" treatment to guarantors' losses, and it is not without significance that the Senate Report on 166 (f) stated: "If the requirements of this section are not met, the taxpayer will, as under present law, be treated taxwise under whatever provisions of the code are applicable in the factual situation." 16 It is true that 166 (f) provides that any payment included therein "shall be treated as a debt"; but of more significance is the fact that the person claiming the deduction need not show that he in fact owned a "debt" or that such debt had "become worthless during the taxable year" - the requirement for deductibility of both business and nonbusiness bad debts under 23 (k) (1) and (4) - since "for purposes of this section" ( 166 (f)) the guarantor's loss is "treated as" a debt "becoming worthless within such taxable year" as the loss occurs. In other words, though assimilated to a "debt" loss, the loss arising from the guaranty payment in fact need have none of the attributes of a debt loss in order to be deductible. The primary thrust of [352 U.S. 82, 102] 166 (f) was to make deductible some kinds of losses which were theretofore not deductible, and I think that drawing from the language of the Section a definitive characterization of such losses as "debts" involves a misplacing of emphasis.
Of still greater significance is the fact that 166 (f) losses are deductible in full. This, it seems to me, is more consistent with the view that Congress did not intend to disturb the line of cases which, following Fox, gave a full deduction under 23 (e) (2) to losses on guaranties of corporate obligations, than it is with the Court's view that 166 (f) confirms Congress' intent that such losses should be only partially deductible as nonbusiness bad debts under 23 (k) (4). Otherwise we would have the anomalous result that under the 1954 Code individual guarantors of noncorporate obligations are given better treatment than those guaranteeing corporate obligations, even though the basic limitation which Congress imposed upon the deductibility of 166 (f) losses, namely, that the proceeds of the guaranteed obligation "were used in the trade or business of the borrower," is always present in the case of a guaranty of a corporate obligation.
In short, I think that when the purposes and provisions of 166 (f) are taken together, it is quite evident that the section was intended to complement the decisions of these four Courts of Appeals, 17 and not to override them.
Finally, the Government suggests that giving guarantors' losses the same capital loss treatment as nonbusiness debt losses would make for a better tax structure, since, it is argued, both kinds of losses are comparable to losses from investments, which receive capital loss treatment under both the 1939 and 1954 Codes. 18 Even if that be so, this would be a matter for Congress. Our duty is to take the statute as we find it. I would reverse.
[ Footnote 1 ] "[ 23 (k)] (4) NON-BUSINESS DEBTS.
[ Footnote 2 ] " 23. DEDUCTIONS FROM GROSS INCOME.
[ Footnote 3 ] 224 F.2d 947.
[ Footnote 4 ] Third Circuit.
[ Footnote 5 ] Fifth Circuit.
[ Footnote 6 ] Sixth Circuit.
[ Footnote 7 ] Third Circuit.
[ Footnote 8 ] "[ 166] (f) GUARANTOR OF CERTAIN NONCORPORATE OBLIGATIONS. - A payment by the taxpayer (other than a corporation) in discharge of part or all of his obligation as a guarantor, endorser, or indemnitor of a noncorporate obligation the proceeds of which were used in the trade or business of the borrower shall be treated as a debt becoming worthless within such taxable year for purposes of this section (except that subsection (d) shall not apply), but only if the obligation of the borrower to the person to whom such payment was made was worthless (without regard to such guaranty, endorsement, or indemnity) at the time of such payment."
[ Footnote 9 ] I. R. C., 1939, 23 (k) (1), 53 Stat. 13, 26 U.S.C. (1940 ed.) 23 (k) (1).
[ Footnote 10 ] H. R. Rep. No. 2333, 77th Cong., 2d Sess. 45.
[ Footnote 11 ] Had this been the congressional purpose, it could have been accomplished simply by subjecting nonbusiness debt losses to the provisions of the statute dealing with worthless securities. See 23 (g) (2)-(4) of the Internal Revenue Code of 1939.
[ Footnote 12 ] When it enacted 23 (k) (4) Congress left undisturbed 23 (e) (2) relating to the deductibility of losses on "any transaction entered into for profit," and that section was subsequently re-enacted, unchanged, as 165 (c) (2) of the Internal Revenue Code of 1954.
[ Footnote 13 ] See note 8, supra.
[ Footnote 14 ] " 23. DEDUCTIONS FROM GROSS INCOME.
[ Footnote 15 ] The Senate Report on 166 (f) simply states: "Your committee also provided that business bad debt treatment will be available where a noncorporate taxpayer, who was the endorser (or guarantor or indemnitor) of the obligation of another, is required to pay the other's debt (and cannot collect it from the debtor). However, this treatment is to be available only where the debt represents money used in the other person's trade or business. Your committee believes that this treatment should be available in such cases since in most cases debts of this type usually are incurred because of business relationships." S. Rep. No. 1622, 83d Cong., 2d Sess. 24-25.
[ Footnote 16 ] S. Rep. No. 1622, 83d Cong., 2d Sess. 200. (Italics supplied.)
[ Footnote 17 ] Ante, p. 97.